Foreign Exchange Market

What is it?

To buy foreign goods and services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their country�s currency or in US dollars, which are accepted all over the world.

When Canadians buy oil from Saudi Arabia they may pay in US dollars and not in Canadian Dollars or Saudi Riyals, even though the United States is not involved in the transaction.

The foreign exchange market or the �FX� market is where the buying and selling of different currencies take place. The price of one currency, in terms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by telephone lines and computer screens � there is no central headquarters. There are three main centers of trading, which handle the majority of all FX transactions � United Kingdom, United States and Japan.

Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day. The London market opens when the Japanese and Hong Kong markets are about to close. While the London market is in its half-day, the New York market opens. San Francisco market opens after trading in London get over. Japan resumes trading when San Francisco market closes down.

The FX market is fast paced, volatile and enormous � it is the largest market in the world. On an average the market records over $1.2 trillion a day.

Who are the Market Participants?

There are four types of market participants � banks, brokers, customers and central banks.

Banks: They and other financial institutions are the biggest participants. They earn profits by buying and selling currencies from and to each other. Roughly two-thirds of all FX transactions involve banks dealing directly with each other.

Brokers: They act as intermediaries between banks. Dealers call them to find out where they can get the best price for currencies. Such arrangements are beneficial since they afford anonymity to the buyer/seller. Brokers earn profit by charging a commission on the transactions they arrange.

Customers: They are mainly large companies, which require foreign currency in the course of doing business or making investments. Some even have their own trading desks if their requirements are large. Other types of customers are individuals who buy foreign exchange to travel abroad or make purchases in foreign countries.

Central Banks: They act on behalf of their governments; sometimes participate in the FX market to influence the value of their currencies.

With more than $1.2 trillion changing hands everyday, the activity of these participants affects the value of every dollar, pound, yen or euro.

• To earn short-term profits from fluctuations in exchange rates
• To protect themselves from loss due to changes in exchange rates, and
• To acquire the foreign currency necessary to buy goods and services from other countries

Foreign Exchange Rates: Most common contract with foreign exchange occurs when we travel or buy things in other countries.

Suppose, an US tourist traveling in India wants to buy a pair of clothes worth 1000 rupees.

If the current exchange rate is Rs.45 per dollar, then the tourist will have to shell out 22.22 dollars. If the exchange rate increases to Rs.40 per dollar, the tourist will have to shell out 25 dollars. If the exchange rate falls to Rs.50 per dollar, the tourist will have to shell out 20 dollars. Thus, small changes in exchange rates may not seem significant. But when billions of dollars are traded, even a hundredth of a percentage point change in exchange rates become important.

A stronger Indian Rupee indicates that Indians can buy foreign goods more cheaply. However, foreigners would find Indian goods costlier. Hence, a strong Indian rupee would help imports and discourage exports.

Alternatively, a weak Indian Rupee indicates that foreign goods for Indians would be costly and foreigners would find Indian goods cheap. Hence, a weak Indian rupee would help exports and discourage imports.

Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk. Exchange rates affect the prices of imported goods, the overall level of price and wage inflation, influences tourism patterns, consumer�s buying decisions and investors� long-term commitments.

Determinants of Foreign Exchange Rates: Exchange rates respond directly to all sorts of events, both tangible and psychological-

• Business Cycles;
• Balance of payment statistics;
• Political developments;
• New tax laws;
• Stock market news;
• Inflationary expectations;
• International investment patterns; and
• Central bank policies.

At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall.

The supply of a nation�s currency is influenced by that nation�s monetary authority, usually its Central Bank, consistent with the amount of spending taking place in the economy. Government and central banks closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals.

Too much money in the economy would spiral inflation decreasing the value of money. Prices would increase. Too little money, on the other hand, would slow down economic growth thereby increasing unemployment.

Monetary authorities must decide whether economic conditions call for a larger or smaller increase in the money supply.

Sources for currency demand on the FX supply

The currency of a growing economy with relative price stability and a wide variety of competitive goods and services will be more in demand than that of a country in political turmoil, with high inflation and few marketable exports.

Money will flow to wherever it can get the highest return with the least risk. If a nation�s financial instruments, such as stocks and bonds, offer relatively high rates of return at relatively low risk, foreigners will demand its currency to invest in them.

FX traders speculate within the market about how different events will move the exchange rates. For example, news of political instability in other countries drives up demand for US dollars as investors are looking for a �safe haven� for their money. A country�s interest rates rise and its currency appreciates as foreign investors seek higher returns than they can get in their own countries. Developing nations undertaking successful economic reforms may experience currency appreciation as foreign investors seek new opportunities.

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is needed everyday may be used for varied purposes:

• For the import and export needs of companies and individuals
• For direct foreign investment.
• Political developments;
• To profit from the short-term fluctuations in exchange rates.
• To manage existing positions.
• To purchase foreign financial instruments.

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents� strategies, they can act first and beat the competition.

Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price.

To predict the movements of currencies, traders often try to determine whether the currency�s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country�s economy helps them make a determination.

• If the currency is under priced then the price will go up.
• If the currency is over priced then the price will go down.

Currency Trading Between Banks: Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in two ways � trough a broker or directly with each other.

Brokers: If a US bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and the seller without ever taking a position and charges a commission to both the buyer and seller. About a third of transactions are arranged in this way.

Direct: Mostly banks deal with each other directly. A trader �makes a market� for another by quoting a two-way price i.e. he is wiling to buy or sell the currency. The difference between the two price quotes (the spread) is usually no more than 10 pips, or hundredths, of a currency unit.

Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, the New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many US dollar would equal one unit of those currencies.

The currencies of the world�s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by four currencies: the US dollar, the Euro, the Japanese Yen and the British Pound. Together these account for over 80% of the market.

It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft countries, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.

Types of Transactions:

Spot Transactions: This type of transaction accounts for almost a third of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate. Although spot transactions are popular, they leave the currency buyer exposed to some potentially dangerous financial risks.

Forward Transactions: One way to deal with the FX risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future and the transaction occurs on that date, regardless of what the market rates are then. The date can be a few days, months or years in future.

Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates � for example, 500,000 British pounds for next November at an agreed rate. These contracts are traded on a separate exchange set up for that purpose.

Swap: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

Suppose, a US company needs 15 million Japanese Yen for a three-month investment in Japan. It may agree to a rate of 150 yen to a dollar and swap $100,000 with a company willing to swap 15 million yen for three months. After three months, the US company returns the 15 million Yen to the other company and gets back $100,000 with adjustments made for interest rate differentials.

Options: To address the lack of flexibility in forward transactions, the foreign currency option was developed. An option is similar to a forward transaction. It gives its owner the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.

For a price, the market participant can buy the right, but not the obligation, to buy or sell a currency at a fixed price on or before an agreed upon future date. The agreed upon price is called the strike price.

Depending on which � the option rate or the current market rate � is more favorable, the owner may exercise the option or let the option lapse, choosing instead to buy/sell currency in the market. This type of transaction allows the owner more flexibility than a swap or futures contract.

• An option to buy currency is called a Call option
• An option to sell currency is called a Put option.

In all of these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that cannot be affected by any changes in the market rates. These tools allow the market participants to plan more safely, since they know in advance what their FX will cost. It also allows them to avoid an immediate outlay of cash.

Floating and Fixed Exchange Rates: The FX market was not always quick to respond to changing events. For most of the 20th century, the exchange rates were fixed, or kept constant, according to the amount of gold for which they could be exchanged. This was called the gold-exchange standard. Under this system, the value of all currencies was fixed in terms of how much gold for which they could be exchanged. For example, if one ounce of gold were worth 12 British pounds or 35 US dollars, the exchange rate between dollars and pounds would remain constant at just under three to one.

• It served as a common measure of value.
• It helped keep inflation in check by keeping money supply in the gold-exchange standard economies fairly stable.
• Long-term planning was easier as rate changes were infrequent.

This system was put in place in 1944, when the leaders of allied nations met at Bretton Woods, New Hampshire, to set up a stable economic structure out of the chaos of World War II. The US dollar was fixed at $35 per ounce of gold and all other currencies were expressed in dollar.

The Bretton Woods system began to weaken in the 1960s, when foreigners accumulated large amount of US dollars from post World War II aid and sales of their exports in the United States. There were concerns as to whether the US had enough gold to redeem all the dollars. With reserves of gold falling steadily, the situation could not be sustained and the U.S. decided to abandon this system. In 1971, President Nixon announced that U.S. dollars would no longer be convertible into gold. By 1973, this action led to the system of floating exchange rates that exist today. Currently, currencies rise and fall in value according to the forces of demand and supply.

After the abandonment of the gold-exchange standard, the foreign exchange market went from a relatively unimportant financial specialty to the forefront of international economics.

Role of Central Banks: Despite the size and importance of the foreign exchange market, it remains largely unregulated. There is no international organization that supervises it, not any institution that sets rules. However, since the advent of the flexible exchange rate system in 1973, governments and central banks occasionally intervene to maintain stability in the FX market.

There is no standard definition of instability or a disorderly market circumstance must be evaluated on a case-by-case bass. Sharp rapid fluctuation of exchange rates and traders� reluctance to be ready to either buy or sell currencies may be signs of disorderly market.

To restore stability, the central banks often work together. However, a country taking a conservative view on intervention would act only in response to unusual circumstances that require immediate action, like political unrest or natural disasters. Most monetary authorities would be less likely to intervene to counteract the fundamental forces that drive FX markets, such as trade pattern, interest rate differentials and capital flows.

Intervention: The Central Bank buys the currency of their country and sells foreign currencies to support the value of their currency. It also sells its currency and buys foreign currency to try and exert downward pressure on the price of its currency.

The transactions in the intervention are small compared to the total volume of trading in the FX market and these actions do not shift the balance of supply and demand immediately. Instead, intervention is used as a device to signal a desired exchange rate movement and affect the behavior of investors in the FX market.

Usually, intervention operations are undertaken in coordination with other central banks. The New York Fed often intervenes in the FX market as an agent for other central banks and international organizations to execute transactions related to flows of international capital.

Some countries have special arrangements with other countries to help them keep their currencies stable. Many less developed countries have their soft currencies pegged to hard currencies, so their value rises and falls simultaneously with the stronger currency. Some peg, or target, their currency to a basket of hard currencies, the average of a group of selected currencies.

Countries that are part of the European Union had pegged their currencies to the euro. There were formulas set for converting from the euro to the currency of each member nation. However, since January 2002, all currencies that were part of the Economic and Monetary System of the EU ceased to exist.

Intervention in the FX market is not the only way monetary authorities can affect the value of their countries� currencies. Central banks can also affect foreign exchange rates indirectly by influencing interest rates. If the interest rates in Germany were 8% and in U.S. were 3% then demand for German Mark will increase.

Gross Domestic Product: The total value of goods and services produced within the borders of the country, regardless of who owns the assets or the nationality of the labour used in producing that output. The growth of output is measured in real terms, meaning increases in output due to inflation have been removed.

Gross National Product: It measures the output of the citizens of the country and the income from assets owned by the country�s entities, regardless of where located.

Consumer Price Index: An index designed to measure the changes in price of a fixed market basket of goods and services. The market basket of goods and services is representative of the purchases of a typical urban consumer. The index is intended to measure pure price change only; attempts are made to remove changes in price resulting from changes in quality.

Industrial Production / Capacity Utilization: An index designed to measure changes in the level of output in the industrial sector of the economy. The index is grouped by both products (consumer goods, business equipment, intermediate goods and materials) and industry (manufacturing, mining and utilities).

Retail Sales: It is an estimate of the total sales of goods by all retail establishments in the country. Data are presented in the nominal or current values, meaning they are not adjusted for inflation. However, the data are adjusted for seasonal, holiday, and trading-day difference between the months of the year. Sales are categorized by the type of establishment not by the type of goods, etc.

Yield on 10-Year Paper: It is the current market interest rate or yield on a 10-Year Government of India Security maturing 10 years in future.

M2: A measure of the nation�s supply of money, defined as M1 (currency in circulation, demand deposits, travelers� cheques, and other checkable deposits) plus non-institutional money market fund and small time savings deposits.